What the rate hike means to you

Understanding the news For starters, you’ll see the Fed increase show up in the rates for home equity lines of credit, car loans, savings accounts and credit cards. How quickly depends on the product, with rates ratcheting up within days for some (such as variable-rate credit cards) and within weeks for others (such as car loans). Because mortgage rates move in anticipation of interest rate increases rather than after the fact, they’ve climbed already.

To really understand what’s going on, however, you need to understand the rates at issue. The Federal Reserve can influence the economy by changing the federal funds rate or the federal discount rate or both. Although those rates are very different, a change in either has the same effect: Increases slow the economy and prevent inflation; decreases spur economic growth. The Fed changes rates through theFederal Open Market Committee, a policy setting group within the broader agency.

The discount rate is the rate at which the Fed lends money directly to banks. Changes in it generally have been irregular.

From 1980 through 1990, for example, there were only 29 rate changes. However, the moves tend to come in flurries. The Fed cut the discount rate seven times in a period of economic sluggishness from December 1990 to July 1992 — to 3 percent from 7 percent ultimately. From May 1994 to February 1995, when the Fed was concerned about the threat of inflation, it raised the discount rate four times — from 3 percent to 5.25 percent. The last time the discount rate changed was Nov. 16, when the Fed raised it by 25 basis points, or one-quarter of a percentage point, to 5 percent.

How the funds rate works

The funds rate works differently. Banks do not earn any interest on the money they are required to have on deposit with the Federal Reserve. When reserves climb above the minimums required, banks gladly loan out that excess to other banks that need to add money to their reserves. The lending banks charge interest for this service. The rate of interest they charge is known as the federal funds rate or funds rate.

This rate jumps around all the time. It last changed in November, when the Fed raised it 25 basis points to 5.5 percent.

While the Fed sets the base or benchmark rate that banks charge, the funds rate actually fluctuates quite a bit on a very short-term basis. That’s because of supply and demand. If there is a lot of demand for money, banks can charge each other a higher rate. Their negotiations go on all day long, making the funds rate one of the most volatile national rates.

Direction is critical

When a Fed change is announced, the direction (up or down) of the change is critical. Increases in the discount rate generally reflect the Fed’s concern about inflationary pressures, while decreases often reflect a concern about economic weakness.

How does this affect you? Think of the bank as a wholesaler. If it costs your bank more to borrow, that cost is passed on to you. If the rate drops, those savings are also passed along.

This is most frequently done in the form of the bank’s prime rate. The prime rate is the rate charged by a bank to its “best,” or prime, customers. It is often used as an index, or base rate, for home equity loans, home equity lines of credit and credit cards. Therefore, when the prime rate changes, the rate you are charged for those loans will adjust accordingly. If your rate goes up, so will your payments. It also has a positive effect in that banks pay you more for your deposits.

What to expect from an increase

Now, without delving too deeply into monetary policy, let’s look at what you need to know as a consumer. A newspaper headline reads: “Greenspan says increase near.” Translation: The chairman of the Federal Reserve Board of Governors, Alan Greenspan, thinks that the economy is growing too fast.

If the economy is growing fast, then inflation will set in. Inflation increases everyone’s cost of living. The Fed doesn’t want this, so the committee increases the discount rate, the funds rate or both. The banks pass the increased cost of doing business along to the ultimate users of credit — consumers.

How do consumers react? The increased cost of credit makes the monthly payment on that new refrigerator too high. As a result, they don’t buy it this month. The stores don’t sell their inventory as quickly, and they cut back on factory orders. The factory doesn’t get as many orders, so management slows the assembly lines. They don’t want to produce goods they cannot sell. Factory workers put in less overtime, or they get laid off. They don’t have as much money to spend, so they cannot buy as much. The cycle continues and the economy slows down, inflation is averted and Greenspan and his fellow board members enjoy the warm glow of knowing they have saved us from destruction.

Capital markets react

There is a secondary effect to any change, or even rumored change, in Fed policy. It affects all of the capital markets (stocks and bonds).

The Fed, by making a change in the rates or suggesting it might do so, is in fact making a statement about the economy. This causes all of the capital markets to shift their rates to meet the Federal Reserve’s expectations. The markets drive yields on all types of bonds, including U.S. Treasury obligations and mortgage-backed securities made up of bundled home loans, higher or lower as part of the process. Because those yields are used as benchmarks for mortgage rates, consumers see more or less expensive home loans even before the Fed actually hikes the rates it controls directly.

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